Investing at a Young Age
Why should I be investing at a young age?
I hear this question a great deal from my friends and a quick search on the internet finds it echoed frequently in online forums. This makes me wonder, with all this literature out there, how come we don’t see more savings from young professionals? I believe much of the answer can be explained by opportunity cost miscalculations (more on that later!), but I think a lot of people just simply don’t consider the numbers in visual terms. Hopefully I can help with that.
I imagine most of you are familiar with the term compound interest; earning 5% on $100 one year means the next year you’re earning on $105, and so on and so forth. I think the hardest part about compound interest is trying to visualize just how long it takes to make it worth something. Coming back to the $100 example, consider this. Annualizing at 5% a year, it will take you about fourteen years to have $200. Why is that? Compound interest is a geometric series – a progression in math where a sequence of numbers is multiplied by a common, fixed number which in this case 5% – so earning 5% on $100 nets you $105, and then next series will be the sum of $100 times 5%, plus $5 times 5% which is $.25. Then the next series will have all that plus $.25 times 5%. Conceptually, starting with $100, you’re adding $5 plus smaller and smaller increments with each compound. If we weren’t using compound interest, it would take you exactly twenty years (100/5) to get an extra $100 – but adding those smaller and smaller increments shaves a cool six years off that total. The power of compound interest is real! Geometric series are a pretty neat thing to think about; however, understanding them, for the purpose of this post, isn’t necessary. And no, there won’t be a quiz later. So how does compound interest apply to you?
I’d like to present a scenario of three friends: Adam, Bill, and Chris. They’ve been friends since college, but all went into separate career fields. The three of them took a personal finance course in college and understand the importance of budgeting and trying to save at least 20% of their income. They also have a moderate risk appetite and earn a 5% return over the course of their investing timeline (some years are good, some years not so much).
Adam went into social work – he investigates child abuse complaints for DCF. It’s a difficult job, that doesn’t pay very well, but he finds it very fulfilling. He makes just at $40,000 a year. Knowing he has a long road ahead of him, he begins investing his first year. He has his government sponsored investment plan which has a pretax deduction of 3% from his income with 100% matching and he also set up a Traditional IRA through his bank which he sets aside $450 a month for a combined $650 contribution per month. He initially invested $5,000 for his account and will be in the market for the next 40 years.
Bill chose not to invest in his retirement, but rather his experiences and took trips and had fun for his first 10 years while working at a local hospital in HR. He thought his money would be more useful now, and figured he had plenty of time before he retired. The experiences and interactions he gained spending would be retirement funds on vacations and travel earned him a middle management job earning $60,000 a year and a few underlings to manage. He invests in a company sponsored IRA which uses a mixture of T. Rowe Price and Liberty Mutual funds. He sends a pre-tax deduction of $1,000 a month and consolidated a $10,000 account into his work IRA. Bill has 30 years in the market.
Finally, Chris was able to snag himself a $100,000 a year job as a compliance auditor; however, it came at a huge cost. He was unable to invest heavily in retirement because of his continuing education and networking soirees – friends don’t come cheap sometimes – and he also had to live in a little more expensive neighborhood for commuting and appearance purposes. Luckily his firm provides a generous 401(k) matching up to 5% of salary and he doesn’t leave a dime on the table. He contributes the full $18,000 a year, with employee matching of $5,000, for a combined $23,000 a year. He also rolled over all of his savings of $25,000 into his investments as a starting deposit. Sadly, Chris only has 20 years in the market.
As you can tell from the graph, slow and steady wins the race. Adam, even with the smallest monthly contributions and starting value, ends up with the biggest acorn in the tree. A public service employee, living within their means, can be a millionaire at retirement. This graph does have its inherent downfalls, most notable is that it doesn’t factor wage increases; however, it provides a great visual as to why someone should invest at 25. Money begets more money so plant your tree early!
The Money Horizon
So here’s the real rub. $1,000,000 sounds like a big chunk of money – and it is if you were spending it over the course of 10 years – but realistically, retiring at 65, you’ll need to have that last for at least 20 years. Withdrawing that equally over the years is $50,000 a year; if you were hoping to not touch the principal, and earning a conservative 4% a year, you’re withdrawing $40,000. Realistically, you’re probably doing both and taking the $50,000, thus draining the account by $10,000 a year.
So where does that leave our college friends? Adam is flying high! He’s earning more money in retirement than he was on salary. Both Bill and Chris are a little more pressed. Neither of them reached the seven figure mark, and both were adjusted to living on $60,000 and $100,000 respectively – I hope they seriously cut costs out as they neared retirement, because they’re about to take a pay cut.
So why don’t we invest more for retirement? The answer is simple and three pronged. The first is that time doesn’t scale well. At 25 years old, being 40 seems like an eternity away. It’s very difficult to see that you’re closer to 40 than you were to being born – if you think life has flown by to this point, just think how quickly the next 15 will go. The next two are fairly interrelated. Media and society make us think that we need more than we actually do to survive: new iPhones every two years, a new car, big house. All those things are nice, but not if you can’t afford them. However, and here’s the killer, ease of access to credit makes “affording” all those things easy. Except owning debt isn’t affording it.
In economics, this is called opportunity cost. You’re foregoing spending later (retirement) to buy that new iPhone now. It’s a dangerous game to play since time lost is time you can’t gain back. So how does a young professional deal with opportunity cost? Luckily the answer is simple! You just need to set aside the money now, preferably in a pre-tax account so you never even see it, and then increase your deductions as your wage increases; if you receive a 5% raise, make sure you increase your contributions by 5%. While it’s helpful to create timelines and predictions about future earnings, you can’t base your retirement contributions on those – you can only rely on the facts that currently apply to you. The goal of investing for retirement now, rather than relying on potential future earnings, is to create “consumption smoothing”. That is, being able to have the same lifestyle you’re accustomed to now even while you’re in retirement.
Hopefully you’re saving at least 20% of your income. Personally, I save right around 27% of my pre-tax income. I could be saving more, but I’m also using after-tax income to pay down my car loan. Using that extra money is essentially earning me a 5.8% return on investment and I’ll have it paid off later this year – which frees up some cash flow to be put towards other things!
So what are my reader’s saving percentages and what are you doing to increase your retirement accounts? Is saving painful for you? What tips can you share about your financial situation? Be sure to check in soon though, my next post will be all about the different investment vehicles you can use. I’ll be wading through the terms and helping you make informed choices about your cash flow.